Europe is a currency saint but an egregious demand sinner

This year’s burst of euro strength has brought crisis closer and baked a lot of future damage into the 17-nation bloc


Be careful what you wish for. The euro’s founding fathers dreamed of a superpower currency that could stand toe-to-toe with the dollar, freeing Europe from US monetary hegemony.

France’s Charles de Gaulle liked to grumble that America enjoyed an “exorbitant privilege” as holder of the world’s reserve currency, able to get away with economic murder. Now they have such a trophy themselves, only to discover what Washington learned the hard way: it is an exorbitant burden, and at times a curse.

China’s central bank has been buying fistfuls of euros as it accumulates a world record $3.7 trillion in foreign reserves, and its motives are not entirely friendly. So have the central banks of Russia, Brazil, and the Mid-East oil sheikdoms, all aiming to cut reliance on the US dollar, part of a $9 trillion build-up in reserves that has flooded into the euro with tidal force.

In China’s case, the government is deliberately driving down the yuan to capture export share. You could say China is exporting excess manufacturing capacity to Europe, or in plain talk exporting unemployment.

This is why the euro has long been too strong for its own good, though there are many other reasons. By forcing banks to raise capital buffers too quickly, in a pro-cyclical fashion at the wrong moment, the EU authorities are unwittingly causing many of them to sell assets across the world. It is hard to find figures on repatriation flows but Morgan Stanley estimates that the sums have been large enough to drive the exchange rate.

The euro surged a further 9pc against the dollar from June to early October before hitting the wall this week. It has risen by 30pc against the Japanese yen in a year. This is a bizarre state of affairs for a currency bloc struggling to emerge from recession, badly lagging the rest of the world. Weak prospects normally mean a weak currency, but there is nothing normal about the mechanisms of Europe’s monetary union.


How the euro has performed against the yen in recent years

The euro exchange rate is too high for two thirds of the euro states that use it, and cripplingly high for a third of them. It is pushing Europe’s crisis economies into incipient 1930s deflation, making it almost impossible for Italy, Spain, and Portugal to dig their way out of debt traps. It is partly why unemployment keeps going up, reaching an all-time high of 12.2pc in September — 26.6pc in Spain, and over 22pc in Italy if properly counted.

Note that unemployment in the US and the Eurozone were similar during the Lehman crisis. Both sides of the Atlantic had much the same credit shock in 2008-2009, yet the aftermath speaks of two different destinies. The Americans printed money a l’outrance, and the jobless rate has fallen steadily to 7.2pc. The Europeans let money atrophy, and have been paying the price ever since. Such is the power of central bank stimulus in a tight corner.


Eurozone (blue line) versus US unemployment

Some insist that the euro is not overvalued, citing the bloc’s current account surplus, €53bn over the last quarter and heading for €200bn a year. But as the US Treasury said in its blistering critique on Thursday, this is largely due to crushed internal demand (austerity) and the structural “export dependence” of the German economy.

Washington said Germany now has a bigger surplus in absolute terms than China, reaching 7pc of GDP earlier this year. This has “hampered rebalancing” in the eurozone at a time when the South is being forced to slash demand. “The net result has been a deflationary bias for the euro area, as well as for the world economy,” it said.

“In 2012, the euro area, in aggregate undertook one of the most aggressive fiscal consolidations of the advanced economies despite having the smallest cyclically-adjusted fiscal deficits and weak growth prospects,” it said. The US Treasury is being polite. What they really mean is that the pre-Keynesian, pre-monetarist, zero-sum Malthusians running EMU policy are a danger to the world.

Europe may not be a currency manipulator but it is most certainly a demand manipulator. This can be worse, even if Europe itself is the chief victim of its economic crime.

The IMF joined the fray on Friday, calling on Germany to cut is surplus to an “appropriate rate”. Germans tend to react with consternation to such criticism, asking why they are rebuked for being good exporters. But this is our old friend the “household fallacy”, as if economies should somehow resemble hard-working thrifty families. The word used in the German political and media debate for fiscal cuts is “Sparen”, meaning to save. The confusion is embedded in the language, and therefore by the ‘Sapir–Whorf hypothesis’ in German thought as well.

Whenever a country has a chronic surplus, there are always deep structural reasons. The legal and commercial system is invariably geared towards generating such surpluses, and over time this comes at the expense of workers in other countries. You don’t have to scratch far below the surface in Germany to find such structures. Why do German households have to pay a premium on their electricity bills to cross-subsidise much cheaper energy for industrial exporters? Why is it even allowed under global trade rules? It obviously compresses internal demand.

Normally, we all turn a blind eye. But in a deformed world of deficient demand and excess capacity, a trade depression of sorts, such surpluses are a very sore subject indeed. This is what the 1930s was all about. Trade disputes were behind much of the conflict leading up to World War Two, especially in the Far East.

Let us hope that Europe is at last waking up to the dangers of its contraction policies after last week’s shock, a fall in EMU-wide inflation for October to 0.7pc. This is worse than it looks. Once austerity taxes are stripped out, prices have been falling in ten of Euroland’s 17 states over the last four months, including Italy, France, and Spain. They are one shock away from outright deflation

France’s industry minister Arnaud Montebourg asks why Europe is permitting this euro asphyxiation, alone in refusing to protect its societies while rivals steal a march. The US Federal Reserve and the Bank of England have averted deflation traps by printing money, nudging down their currencies in process. The Bank of Japan has torn up the rule book altogether, and quite rightly so. The Swiss have quietly trumped them all, boosting the central bank balance sheet to 80pc of GDP to cap the franc.

“Every 10pc rise in the euro costs France 150,000 jobs,”said Montebourg. “Britain, the US, Japan, all have a strategy of monetary stimulus, but in the EU we have nothing but hard money and hard budgets. The currency doesn’t belong to bankers, and it doesn’t belong to Germany, it belongs to all members of the eurozone, and we have something to say about this,”

Is that a threat to invoke Article 219 of the Lisbon Treaty giving EMU ministers the final say over the exchange rate, a power that lets them dictate monetary policy by the back-door, provided the Commission plays ball?

A Deutsche Bank study said the euro “pain threshold” for Germany is $1.79 to the dollar. It is $1.24 for France, and $1.17 for Italy, a staggering difference. The euro ended last week at $1.35. This means Germany is sitting pretty, and it is Berlin that dominates the policy machinery. It has not felt much pain, though as you can see in the chart, it has not done that well wither. Its industrial output is still below its 2008 peak.


German industrial output

Meanwhile Italy is screaming with pain, its industrial output 26pc below the peak, a much bigger fall than during the Great Depression. I was in the room with a panel of Italian businessmen at Lake Como in September when Italy’s EU commissioner Antonio Tajani warned of “a systemic industrial massacre” and demanded immediate action to force down the euro. The hall erupted in applause.


Italian industrial output

The North-South split has many causes needless to say. Germany sells high-tech machines and prestige cars with a fat profit margin. They are not sensitive to price. Southern Europe competes lower down the chain, often in mass markets, against China, Turkey, or Poland.

Yet it is also because Germany screwed down wages in the early years of EMU — when the world was booming, and such a feat was possible — gaining 25pc in labour cost competitiveness against Club Med. Yes, Germany did carry out its famous Hartz IV labour reforms, but this tale is overblown. The gains were largely the result of an “internal devaluation” within the euro. Whatever the original intentions, it became a beggar-thy-neighbour policy over time.

How this happened is by now an old story. But the consequences are very much alive and toxic, so toxic that Francois Heisbourg, French head of the International Institute for Strategic Studies, is calling for the euro to be “put to sleep” in order to save the European Project. “We must face the reality that the EU itself is now threatened by the euro,” he said.

Mr Heisbourg is ardently pro-European. His point is that bitterly conflicting narratives of the crisis are emerging, pitting creditor and deficit states against each other. He compares this to the birth of black legends after World War One, when twisted views fed an ideological backlash. He fears it will end in “a nervous break-down and an uncontrolled disintegration of the euro ”.

This year’s burst of euro strength has baked a lot of future damage into the pie and brought that crisis closer. The European Central Bank has the apparatus to head off the deflation risk and force the euro back down at any time. All it needs to do is to end its contraction policies, meet its own 2pc inflation and 4.5pc M3 money targets, and fulfil its primary EU treaty obligation to promote “balanced economic growth”, “employment”, and “general interest” of the Union.

In my view, ECB is in breach of the treaties. It should be taken to the European Court. Its governors should be called to account by the European Parliament. If the Parliament cannot rise to the greatest and most urgent challenge since its creation in 1979, then we might as well dynamite the Hemicyle in Strasbourg and replace it with a monument to the millions of blighted lives in Mediterranean Europe.

The Latin governors and those of other states in various degrees of distress — making up most of the eurozone population — have so far been acting like the rabbits in the headlights, frozen as the juggernaut hurtles down upon them, unwilling to say boo to the German Bundesbank. We will find out this week if the ECB’s cowed majority is at last willing to take charge of monetary policy and act in the “general interest” of the Union.

Watching from the sidelines, you want to tear your hair out, whatever your views on the European Project. The debt-deflation crisis in Southern Europe could be so greatly mitigated by lifting EMU inflation to 2pc. A littler higher would be even better.

“We all know what has to be done, inflation in the periphery should rise to 1pc, and Germany should have a few years of 3pc inflation. That would change everything. It makes me angry that this is not happening,” said an ex-ECB governor last week. Nothing could be easier, yet nothing is done, and the reasons are entirely political.

Let us praise Europe for carrying the exorbitant burden of reserve currency status. It has not intervened for trade advantage. But the effects of this good behaviour have been overwhelmed by the collateral ruin. The damage done from the triple shocks of fiscal, monetary, and exchange rate tightening is enormous, and it is Southern Europe that is bearing the full brunt.

We can only live in hope that the great, gallant, and generous nation of France will stop moaning, get a grip, assert leadership, and restore basic sanity to European affairs before it is too late. Only Paris has the moral command to pull this off.

Would the late Charles de Gaulle have stood so oddly passive if he were at the Elysee today? He may not have understood currencies, but surely he would have seen straight through the Maginot Line of EMU fiscal fortresses.